United States: The Rise Of The Group Health Insurance Captive

With its "employer mandate"—i.e., the
requirement that applicable large employers make an offer of group
health coverage to substantially all full-time employees or face
the prospect of a penalty—the Affordable Care Act (ACA)
opened a fault line in the previously monolithic market for group
health insurance. There is large cohort of American workers who,
before the ACA, were not offered major medical coverage under an
employer-sponsored group health plan. These employees are sometimes
referred to as the "contingent" workforce. They include
part-time, seasonal and temporary employees, as well as employees
whose work schedules are generally irregular or intermittent. Found
predominantly though not exclusively in industries such as
staffing, restaurants, media and advertising, transportation and
hospitality, among others, these workers tend to be on the lower
end of the pay scale. They also often have significant
"deferred" health issues (a euphemism for undiagnosed
conditions owing to lack of previous access to health care). The
ACA provided "applicable large employers" (those with 50
or more full-time and full-time equivalent employees) with an
incentive to cover these workers.

While the ACA requires mainstream health insurance carriers to
issue policies to employers who cover large cohorts of contingent
workers under the guaranteed issue and renewability rules, carriers
remain free to set rates, which are in many cases unaffordable.
This market is what the insurance industry refers to as a
"hard" market. i.e., one with higher insurance premiums
and more stringent underwriting criteria that together results in
less competition and carriers writing fewer policies.

Large employers (over, say, 500 to 1,000 employees) with
substantial populations of contingent workers can self-fund
coverage for the purpose of complying with the ACA employer
mandate. (For a description of the mechanics and benefits of
self-funding of employer-sponsored group health plans, please see
the white paper published by Spring Consulting Group, LLC entitled,
Self-funding and the
Management of Risk.) These employers benefit from the "law
of large numbers" that holds that, in the group health plan
context, the larger the number of lives independently exposed to
loss, the greater the probability that actual loss experience will
equal expected loss experience. In other words, the credibility of
data increases with the size of the data pool, thereby leading to
predictability. Similarly situated mid-sized employers (between 50
and 500 or so full-time and full-time equivalent employees) are
unable to rely on this axiom, so their options for complying with
the ACA are limited. They could, for example, offer a plan that
required no underwriting such as a "MEC" that covers
preventive services only. This approach gets the mid-sized employer
off the hook for the more serious of the two levels of penalties
(i.e., the excise tax imposed under Internal Revenue Code section
4980H(a)), but it leaves open the possibly of exposure to the other
penalty (under Internal Revenue Code section 4980H(b)). To escape
the latter penalty the employer must generally make an offer of
major medical coverage, or in the parlance of the ACA, coverage
that provides "minimum value."

Association-style plans are also an option for mid-sized
employers, but self-funding is generally not an option, since most
states view self-funded association plans as unlicensed insurance
companies. There is another, less conventional option: though not a
new concept, these mid-sized employers can self-fund, but interpose
a separate layer of stop-loss coverage under a "group
captive" arrangement that includes other, similarly situated
employers. In a group captive, each participating employer
maintains its own self-funded health group health plan. Stop-loss
coverage is purchased from a commercial medical stop-loss carrier
that cedes a portion of the risk to a group captive insurer. The
result is a transfer of responsibility for payment of claims that
fall within a specified corridor immediately above the
employer's retained risk up to a preset amount. The reinsurance
agreement also limits the total amount of claims the
captive is responsible for paying, thereby limiting the
captive's aggregate exposure.

In our experience, these group captive programs have become, if
not ubiquitous, at least commonplace. Moreover, they are being
deployed by mid-sized employers of all stripes, not just those
seeking to cover contingent workers. This post explains the basic
features of these group captive arrangements, reviews and assesses
the legal authority on which they rely, and provides compliance
recommendations.

Background and Scope

The term "captive" insurer traditionally referred to
"single-parent" captive, which is a subsidiary of a
parent company that insures the risks of its parent. Single-parent
captives offer certain tax and risk management advantages.
Historically, single-parent captives insured property and casualty
risks and workers' compensation, but they have increasingly
been pressed into service to cover health risks. In this latter
case, issues arise under the rules governing "prohibited
transactions" under the Employee Retirement Income Security
Act (ERISA).

While a full-blown discussion of the ERISA prohibited
transaction rules as they apply to captives is beyond the scope of
this post, the use of group captives can implicate these rules.
Briefly, ERISA prohibits the "transfer to, or use by or for
the benefit of, a party in interest, of any assets of the
plan." (Emphasis added). Employer-sponsors of plans are
parties in interest pursuant to ERISA, as are entities of which
they own more than 50 percent. Thus single-parent captives, which
are usually 100 percent-owned by the employer must navigate the
ERISA prohibited transaction rules. And while not entirely clear,
it is a safe bet that the same result would apply to a captive cell
where the employer is entitled to more than 50 percent of the
profits.

Key to the use of group captive arrangements is the concept of
what constitutes "plan assets" for purposes of the
prohibited transaction rules. ERISA specifically provides that,
where an insurer issues a guaranteed benefit policy to a plan, such
as a group term life policy, the assets of the plan include the
policy, but not any assets of the insurer. Thus, if a self-funded
plan purchases stop-loss coverage, the premium ceases to be a plan
asset once it has been received by the insurer. But this is not the
case of reinsurance using captives. This issue surfaced in
connection with a 1979 prohibited transaction class exemption
(Prohibited Transaction Class Exemption 1979-41 (August 7, 1979)).
This class exemption permitted insurance companies to underwrite
their own employee benefits provided that the employee benefits
business did not exceed 50 percent of the insurance company's
business. Notably, the Department of Labor was unwilling to extend
this class exemption to reach reinsurance provided by wholly-owned
captives. According to the Department [44 Fed. Reg. 46365,
46368]:

[I]t is the Department's view that if a plan purchases an
insurance contract from a company that is unrelated to the employer
pursuant to an agreement, arrangement or understanding, written or
oral, under which it is expected that the unrelated company will
subsequently reinsure all or part of the risk related to such
insurance with an insurance company which is a party in interest of
the plan, the purchase of the insurance contract would be a
prohibited transaction.

In other words, any amounts deposited with a captive retain
their status as "plan assets" that are subject to the
ERISA prohibited transaction rules. As we explain below, group
captives generally endeavor to side-step the ERISA prohibited
transaction rules by purchasing stop-loss coverage and making group
captive contributions with employer assets rather than
plan assets.

In contrast to a single-parent captive, a group
captive—also referred to as an "association
captive"—is a legal entity jointly owned by a group of
unrelated companies, and it is formed primarily to insure the risk
of its member-owners. Group captives can be further subdivided into
heterogeneous and homogeneous, the former covering dissimilar
industries and the latter covering similar industries. In each
case, the goal is to permit mid-sized employers to replicate the
risk profile of a single large employer, and both types of group
captives are commonplace.

Captives have caught the attention of both the Federal and state
regulators on three fronts unrelated to this post.

Low attachment points

A stop-loss insurer might offer insurance policies with
attachment points set so low that the insurer assumes nearly all
the employer's claims' risk. For example, the attachment
point could be set at $5,000 per employee, or $100,000 for a small
group. While a plan might purport to be self-funded under these
circumstances, the arrangement looks much more like a
fully-insured, high-deductible health plan. The National
Association of Insurance Commissioners (NAIC) has promulgated a
model law that prohibits the sale of stop-loss insurance with a
specific annual attachment point below $20,000. For groups of 50
employees or fewer, the aggregate annual attachment point must be
at least the greater of (i) $4,000 times the number of group
members, (ii) 120 percent of expected claims or (iii) $20,000. For
groups of 51 employees or more, the model law prohibits an annual
aggregate attachment point that is lower than 110 percent of
expected claims. The group captive arrangements that we have
encountered uniformly satisfy these standards.

Micro-captives/abusive tax shelters

A micro-captive arrangement is one in which a taxpayer endeavors
to reduce his or her aggregate taxable income using a combination
of an insurance contract and a captive insurance company. Each
party claims deductions for insurance premiums, and the captive
insurance company elects to be taxed only on investment income,
thereby excluding payments it directly or indirectly received under
the contracts from its taxable income. The IRS in Notice 2016-66 said the manner in
which the contracts are interpreted, administered and applied is
inconsistent with arm's-length transactions and sound business
practices. The group captives that we encounter do not take this
approach.

IRS Revenue Ruling 2014-15 describes and sanctions use of a
captive to reinsure fully-insured health benefits. The ruling
describes an arrangement in which an employer makes contributions
to a funded welfare trust to provide health benefits to certain
retirees and their dependents. The trust then purchases insurance
from a commercial carrier, which cedes a portion of the risk to a
captive 100 percent owned by the employer. Thus, this arrangement
is similar to the group captive arrangements, except that the
arrangement is fully insured. It is also worth noting that the
employer was required, as a one of the conditions for approval of
the arrangement, to obtain a prohibited transaction exemption from
the Department of Labor.

Group Captive Structure and Administration

As we explained above, each participating member of a group
captive establishes and maintains its own, self-funded group health
plan. As a result, each employer can dictate its own plan rules,
including levels of coverage such as copays and deductibles.
Participating self-funded employers can also choose their own
third-party administrators and provider networks, although in our
experience, this rarely happens. Each employer also purchases
commercial medical stop-loss coverage.

Stop-loss coverage reimburses claims when they exceed a
specified amount, referred to as the "attachment point."
Coverage may be "specific," i.e., covering individual
claims, or "aggregate," i.e., covering total annual
claims. An employer may, for example, purchase an aggregate
stop-loss policy that covers claims over 125 percent of total
anticipated annual claims. In contrast, specific stop-loss coverage
may reimburse any individual claim in excess of $50,000.

In a group captive arrangement, the employer enters into a
reinsurance agreement with a commercial medical stop-loss carrier,
under which responsibility for payment of claims in excess of the
level of retained risk separately agreed to by each employer is
transferred to the carrier. The medical stop-loss carrier then
transfers a portion of the risk to the employer/sponsor's
captive pursuant to an "insurance treaty." The
arrangement is analogous to the securitization of mortgage
securities in that the excess risk (that is the risk over and above
the anticipated claims and any additional retained risk) is carved
up in tranches. Under the reinsurance treaty, the captive is
responsible for the tranche immediately above the
employer/sponsor's retained risk up to a pre-set amount. For
example, in the case of specific coverage, the captive's
exposure might start at $50,000 per claim and go to, say, $500,000.
The commercial medical stop-loss carrier would them be responsible
for a claim that exceeds $500,000. In the case of aggregate
coverage, the captive's tranche might pay between 125 percent
and 500 percent of total annual claims. Amounts above 500 percent
would be the responsibility of the commercial medical stop-loss
carrier.

While there are likely many ways to structure group captives, we
routinely encounter two. Under the first approach, the group
captive consists of a series of "fronted" captive cells
that are sponsored by the commercial carrier from who the stop-loss
coverage is purchased. Under the second approach, the group captive
is separately maintained and subscribed to under an enabling state
law. Both approaches accomplish the pooling of stop-loss coverage
at the tranche of risk underwritten by the captive.

In one common model, each employer/member selects the level of
its retained risk, which informs the level of the premium paid for
reinsurance. (The greater the retained risk, the lower the cost of
reinsurance coverage.) The employer/member then pays a premium, a
portion of which is applied to the captive's shared
risk pool. If there are underwriting gains in the shared risk pools
that exceed claims in a year, the excess is returned to the
employer/members pro rata based on premiums and without regard to
the employer/member's individual experience. Going forward,
each employer/member's experience informs the following
year's premiums.

The MEWA Question

ERISA defines the term "multiple employer welfare
arrangement," or "MEWA," in relevant part, as
follows:

(A) The term "multiple employer welfare arrangement"
means an employee welfare benefit plan, or any other arrangement
(other than an employee welfare benefit plan) which is established
or maintained for the purpose of offering or providing any benefit
described in paragraph (1) [welfare plan benefits] to the
employees of two or more [unrelated] employers . .
.."

(For a comprehensive explanation of MEWAs, please see the paper published by
the U.S. Department of Labor entitled, Multiple Employer Welfare
Arrangements under the Employee Retirement Income Security Act
(ERISA): A Guide to Federal and State Regulation.) To be a
"welfare plan" generally requires the plan to be
established by an employer or a union. As explained in a recently
issued Department of Labor advisory opinion, a
plan can be a MEWA without being an employee welfare plan. This
would occur, for example, if a commercial promoter established and
maintained a group health plan covering a group of unrelated
employers

Association health plan distinguished

An "association health plan," i.e., a plan that covers
entities in the same industry, is an example of a MEWA, since the
plan covers employees of two or more unrelated employers.
In order for a group or association to constitute an
"employer," there must be a bona fide group or
association of employers acting in the interest of its
employer-members to provide benefits for their employees. This
requires a "commonality of interest" among the employers.
Most association plans can satisfy these criteria.

For a MEWA to be subject to ERISA requires that the MEWA be an
ERISA-covered welfare plan and that the arrangement cover
employees of two or more unrelated employers. Only MEWAs that
satisfy the Department of Labor "commonality of interest"
standards can satisfy the first criteria—i.e., qualify as an
ERISA-covered welfare plan. This is important because it affects
the extent to which these plans are subject to state law. As a
result of a 1983 amendment to ERISA, states are free to regulate
self-funded association health plans. In contrast, a state's
ability to regulate fully-insured MEWAs is significantly
constrained. Oversimplifying a bit, states may regulate the carrier
that provides coverage to the full-insured MEWA but not the MEWA
itself. As a result, absent special state legislation on the
subject, a self-funded association health plan is an unlicensed
insurance company.

An association health plan that fails the commonality of
interest requirement is subject to regulation under state law
irrespective of whether it is fully-insured or self-funded.

Treatment of group captives

For a group captive of the sort described in this post to work
as advertised, it must be treated as a series or collection of
individual, single-employer group health plans. It must not be a
MEWA. Promoters and sponsors of group captive arrangements
therefore take the position that:

Each employer/sponsor of a group
captive maintains its own, self-funded, single employer group
health plan;

Stop-loss insurance is in the nature
of property and casualty insurance that insures the
employer/sponsor and not health insurance that insures the
employees and their beneficiaries; the former is not subject to
ERISA, only the latter is; and

Because the pooling of risk does not
occur in connection with the providing of health insurance, there
is no plan that covers employees of two or more unrelated
employees—i.e., there is no MEWA.

The claim that stop-loss insurance is property and casualty
insurance covering the employer, and not health insurance covering
employees, is of central importance. There is, however, scant
authority in support, or in derogation, of this claim. There is a
2014 technical release, in which
the Department of Labor concedes that "Stop-loss insurance
generally is not treated as health insurance under State law."
The Department made this statement in the context of opining on the
power of the states to regulate stop-loss polices, so it should not
be read as an endorsement of group captives.

Stop-loss Coverage and the ERISA "Plan Asset"
Rule

In general, if a plan's stop-loss policy is purchased by the
plan, rather than by the employer, then it is considered a
"plan asset" for ERISA purposes. But if the stop-loss
policy is purchased by the employer and is intended to reimburse
the employer, rather than the plan, it is not considered a plan
asset. For a garden-variety self-funded plan (i.e., not involving a
group captive), whether the stop-loss policy is a plan asset is
important only for reporting purposes. If the stop-loss policy is
plan asset, then it must be reported as such on a schedule to the
plan's annual report (Form 5500). But in the case of a group
captive, the stakes are much higher, implicating both the ERISA
prohibited transaction rules and the treatment of MEWAs under state
law.

In a 1992 advisory opinion, the
Department of Labor found that a stop-loss insurance policy
purchased by an employer sponsoring a self-insured welfare benefit
plan to which employees did not contribute would not be an
asset of the plan if the following conditions are satisfied:

The insurance proceeds from the
policies are payable only to the plan sponsor, who is the named
insured under the policy;

The plan sponsor has all rights of
ownership under the policy, and the policy is subject to the claims
of the creditors of the plan sponsor;

Neither the plans nor any participant
or beneficiary of the plan has any preferential claim against the
policy or any beneficial interest in the policy;

No representations are made to any
participant or beneficiary of the plan that the policy will be used
to pay benefits under the plan or that the policy in any way
represent security for the payment of benefits; and

The benefits associated with the
plans are not limited or governed in any way by the amount of
stop-loss insurance proceeds received by the plan sponsor.

Some 13 years later, in a 2015 advisory opinion, the
Department addressed contributory plans. Specifically, the
Department opined that a stop-loss policy purchase by a plan that
included participant contributions would not be a plan asset if the
following conditions are satisfied:

Except for the use of participant
contributions to partly fund medical benefit under the plan, the
facts surrounding the purchase of the stop-loss policies satisfy
the requirements of the 1992 ruling;

With respect to the use of
participant contributions to fund in part the benefits under the
plan, the employer must put in place an accounting system that
ensures that the payment of premiums for the stop-loss policy
includes no employee contributions;

The purchase of stop-loss insurance
must not relieve the plan of its obligation to pay benefits to plan
participants, and the stop-loss insurer has no obligation to pay
claims of participants; and

The policies reimburse the plan
sponsors only if the plan sponsors pay claims under the plans from
their own assets so that the plan sponsors will never receive any
reimbursement from the insurer for claim amounts paid with
participant contributions.

The Department elaborated on the accounting system in the second
bullet point above, saying:

Specifically, participant contributions are paid into the
general account of [the employer] and recorded in a balance sheet.
All health claims and other Plan expenses are paid from this
[employer] general account. The plan sponsors will pay premiums for
the policies, or any other stop-loss insurance, exclusively from a
general account of [the employer].

It is the last requirement that is the most problematic in most
group captives, since it would be unusual for plan sponsors to pay
all claims in full and await reimbursement from the captive or the
stop-loss carrier, as the case may be.

For group captives, the portion of tranche of stop-loss coverage
provided by the captive must not be a plan asset for two
reasons:

Regulation as an unlicensed insurance company under
state law

What makes the group captive concept work is the ability to pool
stop-loss risk. But if this coverage is a plan asset, then the
pooled benefit is available to employees of two or more unrelated
employers—i.e., a self-funded MEWA.

ERISA prohibited transactions and fiduciary
self-dealing

If the stop-loss coverage is a plan asset, transactions with the
captive will in all likelihood run afoul of the ERISA prohibited
transaction rules described above. Employer-sponsors of group
health plans are parties in interest, as are more than
50-percent-owned entities (or those entitled to more than 50
percent of the profits). This includes captive cells where the
employer is entitled to more than 50 percent of the profits. The
payment of premiums to a captive would trigger a prohibited
transaction. In addition, it is possible to envision a violation of
the ERISA self-dealing rules as well, since the employer/sponsor is
also the fiduciary of its own plan, and arranges for that plan to
enter into an arrangement that ultimately benefits the employer
through its ownership interest in the captive. In either case, the
penalties are severe.

Recommendations and Closing Thoughts

Group captives rest on a modestly reliable regulatory
foundation. To be ideally positioned to withstand challenge, group
captives would need to follow to the letter the steps outlined in
the two Department of Labor advisor opinions described above. This
would include the requirement to pay all claims then subsequently
seek reimbursement from the captive or the commercial carrier. The
Department's rationale for this requirement is to ensure that
"Plan Sponsors will never receive any reimbursement from the
insurer for claim amounts paid with participant
contributions." But having the stop-loss pay the excess claims
directly is not only commonplace, it also leaves the parties in the
same financial position as the Department's approach.
Nevertheless, if the Department wanted a way to challenge group
captives that don't comply with this requirement, it could
claim that the stop-loss policies including the captive are plan
assets. We are unaware of the Department taking this approach on
audit of examination.

There is another dynamic at work here. Earlier this year, the
House Education and Workforce Committee approved a measure amending
ERISA to exclude stop-loss coverage for self-insured health plans
from the definition of "health insurance coverage." The
measure appears to be aimed at preventing the states from
regulating stop-loss coverage for small groups. While the measure
has not advanced, it does herald a change in the underlying
politics. The impact on group captives is unclear, however, since
the Committee at the same time reported out a bill intended to
facilitate the formation of multistate small business association
health plans.

It seems that the existing solutions for this particular hard
insurance market—the one relating to contingent
workers—need some help. While group captives appear to
represent a viable market solution, they do not fit neatly into
existing legal and regulatory structures. For now, the best that
that can be said is they fit well enough to be considered a
mainstream solution.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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Surveys & Contests

From time-to-time our site requests information from users via surveys or
contests. Participation in these surveys or contests is completely voluntary and
the user therefore has a choice whether or not to disclose any information
requested. Information requested may include contact information (such as name
and delivery address), and demographic information (such as postcode, age
level). Contact information will be used to notify the winners and award prizes.
Survey information will be used for purposes of monitoring or improving the
functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our
site, we ask them for the friend’s name and email address. Mondaq stores this
information and may contact the friend to invite them to register with Mondaq,
but they will not be contacted more than once. The friend may contact Mondaq to
request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’
information. When users submit sensitive information via the website, your
information is protected using firewalls and other security technology. If you
have any questions about the security at our website, you can send an email to
webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode),
or if a user no longer desires our service, we will endeavour to provide a way
to correct, update or remove that user’s personal data provided to us. This can
usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will
post those changes on our site so our users are always aware of what information
we collect, how we use it, and under what circumstances, if any, we disclose it.
If at any point we decide to use personally identifiable information in a manner
different from that stated at the time it was collected, we will notify users by
way of an email. Users will have a choice as to whether or not we use their
information in this different manner. We will use information in accordance with
the privacy policy under which the information was collected.

How to contact Mondaq

If for some reason you believe Mondaq Ltd. has not adhered to these
principles, please notify us by e-mail at problems@mondaq.com and we will use
commercially reasonable efforts to determine and correct the problem promptly.